Markets Update: Investors Assess U.S.-China Risks

Episode Summary

Executive Summary: Michael Cassell says the dominant market risk is escalating US-China tension, prompting clients to hedge China-related exposure through currencies and proxies. He also highlights a shift in rates thinking: a pinned front end, possible yield-curve control, and a steeper long end driven by heavy Treasury supply and low inflation expectations. The episode notes that post-COVID correlations have broken down, making traditional hedges less reliable.

Main Topics: Escalating US-China tensions (Priority: 5/5): Cassell identifies US-China frictions as the top market story, citing concerns over Hong Kong autonomy, national security law developments, phase one trade deal compliance, and broader geopolitical escalation that is influencing client positioning. China and proxy FX hedging (Priority: 5/5): Clients are using currency hedges to express or protect against China risk, including selling CNH outright, using limited-loss structures, shorting the Taiwan dollar, and selling the Aussie dollar as a proxy trade. US yield curve dynamics and Fed policy (Priority: 5/5): The discussion emphasizes a front end anchored by Fed guidance and possible yield curve control, alongside pressure for long-end yields to rise due to suppressed short rates and future normalization needs. Low inflation expectations and breakeven opportunities (Priority: 4/5): Cassell notes that market-implied inflation is very low, creating opportunities around breakevens and supporting the case for a steeper curve over time. Breakdown in cross-asset correlations (Priority: 4/5): COVID disrupted historical relationships among assets, including bonds, gold, and dollar/yen, making traditional hedges less effective on risk-off days and requiring active navigation of a new regime. Working-from-home personal note (Priority: 1/5): A brief lighter segment covers his experience at home during COVID, including helping a 90-year-old neighbor and getting a hamster instead of a dog.

Key Arguments: US-China tensions have moved from background noise to a primary driver of client behavior and risk management. The path of least resistance for Chinese risk assets appears to be further escalation, so more risk premium may be justified. CNH weakness is not fully priced; options and controlled-devaluation structures are being used because the PBOC is unlikely to allow a rapid disorderly devaluation. The Taiwan dollar and Aussie dollar are being used as hedges/proxies for China exposure because they are sensitive to China-related selloffs. The Fed is likely to keep the front end of the curve pinned for an extended period via guidance and potentially yield-curve control. Low short rates combined with heavy Treasury issuance may eventually push long-end yields higher and steepen the curve. Inflation breakevens are extremely low, presenting a potential opportunity for investors. Post-COVID correlations have changed materially, so conventional risk-off hedges may not behave as expected.

Data Points: Recording date: Thursday, May 28, 2020 - Podcast timestamp disclosed at the end of the episode. Episode date: Friday, May 29, 2020 - Markets update framing the discussion date. CNH forward-implied weakness: About 1% over the next 6 months - Cassell says FX forwards price only a modest decline in the Chinese yuan. Fed hike timing reference: 7 years - He notes it took the Fed seven years to hike after its last cut in 2008. Yield curve control: Discussed as a policy option - Fed leadership is publicly discussing yield curve control to keep front-end yields pinned. Age of neighbor: 90-year-old - Personal anecdote about helping a neighbor during COVID.

Pivotal Quotes: "The escalation in US-China tensions are front and center for our clients and our trading desk." — Michael Cassell: Opening answer on the top market story he is watching. "I think the path of least resistance from here is clearly further escalation." — Michael Cassell: His view on US-China tensions and the direction of risk premium in Chinese assets. "That's a good hedge on return to office." — Jake Siebert: Light joking remark after Cassell mentions getting a hamster instead of a dog.

Implications: Investors should expect more China-related volatility, consider FX and proxy hedges, and reassess traditional correlations. Rates positioning may favor a pinned front end and steeper long end, while low breakevens could offer opportunities.